Tal Lomnitzer, Senior Investment Manager in the Janus Henderson Global Natural Resources Team, explains how oil prices went into negative territory and what this means for oil sector equities and the Team’s outlook.
Oil prices have collapsed this week. New depths have been plumbed, with the May price going negative for the first time in history. Oil supply and demand fundamentals are currently challenged by way too much supply. OPEC’s return to supply discipline is not sufficient to balance a market suffering a collapse in demand due to the COVID-19 Pandemic and associated lockdowns, economic contraction and travel disruption. These fundamentals are the reason that crude oil for May delivery started the week at the already beaten down price of $18 per barrel.
The sharp sell-off to a low of minus $39 per barrel was however driven by dynamics going beyond demand and supply for oil and into the availability of oil storage capacity. Excess supply of crude oil has been filling up the available storage at the main crude hub in Cushing, Oklahoma where this oil is traded. Storage is normally easily accessible. With the May contract for WTI benchmark crude ceasing trade yesterday, financial holders needed to roll their holdings into the June contract. What normally would be a seamless roll-over became a rout. With limited storage capacity, bids in the market for May oil deliveries dried up, allowing prices to plummet. This is great for those that have storage available as price is soaring. Right now, storage is an increasingly scarce resource.
Clearly negative oil prices are an anomaly that can only exist briefly before being arbitraged away. The May price of oil indeed bounced back and ended at $10 per barrel. However, significant damage has been done with the June contract sucked down into this vortex, with knock-ons to the already parlous finances of many oil and gas companies. Further production cuts and possible defaults on debt are likely. Tough times for hydrocarbon producers.
Given renewed OPEC discipline and non-OPEC supply cuts, it is reasonable to expect healthier oil prices over the course of the year and into 2021. Equities are forward-looking and they have indeed been looking through the current oil price weakness. We estimate that large integrated oil companies such as BP and Shell are pricing in around $45 per barrel oil and note that the long term oil price is $55 per barrel. Cuts to oil supply are harsher and more structural than cyclical in this downturn, potentially robbing oil production of the potential to recover into 2021 and beyond. These cuts will have an enduring effect that lasts beyond COVID-19.
In the meantime the landscape is quickly evolving and we would expect to hear positive OPEC rhetoric about commitment to cuts and market support, but it is difficult to see anything substantive. Given the scale of the demand shock, OPEC+ has done pretty much all it can, at least until demand starts to recover.
From an equity perspective, the risk is rising that the second quarter is now starting to look so bad that we could see earlier cuts to dividends than the market expects from some big oil companies.
The Janus Henderson Global Natural Resources Fund (Fund) has been underweight oil producers, with a preference for those companies benefitting from the ongoing carbon transition, such as renewable energy developers and equipment suppliers, or gas producers. Oil stocks still face transition issues that have gone off the radar for now, but are likely to come back once we have passed through the COVID-19 crisis.
It is quite possible that low oil prices accelerate existing trends away from fossil fuels as governments use it to unwind fossil fuel subsidies and use stimulus to boost clean energy programs. The strategy is also invested in storage and shipping companies, as well as refiners, positioning it well for the current low price, tight storage environment.
We have no exposure to oil services companies where the brunt of lower spending from oil companies is likely to be felt. Risk-reward is continually being reassessed as moves that sometimes take months or years to play out have happened in days or weeks.
All prices are in US dollars (USD) unless stated otherwise.